How contango can affect commodity ETFs

Exchange-traded funds (ETFs) are investment funds that trade on a stock exchange. Like a stock, an ETF’s price changes throughout the trading session as shares are bought and sold, and they can be sold short and bought on margin. In addition, ETFs typically are low-cost compared to other investment vehicles, and are considered a relatively simple way to add diversity to a portfolio. Because of their attractiveness to institutional and individual investors alike, ETFs have grown into a $1 trillion industry since the SPDR fund — the first ETF — was launched 20 years ago.

Today, traders and investors can gain exposure to a variety of investment products through ETFs, including bonds, currencies, indexes and commodities (see Futures’ 2013 ETF Guide, page 38). However, even the relatively simple arena of ETF trading has special considerations that must be acknowledged.

In futures-based commodity ETF trading, if the futures contract in which the ETF invests is experiencing contango, the ETF can lose value, resulting in potentially significant — and often unexpected — losses for investors. Here, we will introduce contango and its effect on the futures-based commodity ETF markets, and how traders and investors can mitigate the potentially damaging consequences.

Contango defined

When the forward price of a futures contract is above the expected future spot price, the market is said to be in contango (see “Contango and backwardation in futures markets,” February 2013). This is a fairly common situation because under normal circumstances investors and traders are willing to pay a premium to avoid the inconvenience and costs associated with transporting, storing and insuring a commodity. Further out contracts often are priced higher than current ones.

The price of a futures contract will converge to the spot price as its expiration date approaches as a function of arbitrage, supply and demand. If a contract is priced above the spot price, as is the case with a market that is trading in contango, price eventually must move down to be in line with the spot price. Because contango implies that price must fall, long positions in contangoed markets can lose value. “Contango in action” (below) illustrates this concept.

Although individual investors can participate in the commodity cash market, buying and taking delivery of physical commodities, most prefer the convenience of exploiting price moves by trading an exchange-traded derivative, such as a futures contract or an ETF. ETFs are a popular alternative with the general public because not only do they provide individual investors with direct exposure to a variety of commodities without the limitations of holding the physical assets, but they can be traded in any equity account, just like a stock. Investors can trade ETFs based on various commodity categories, including agriculture (grains and softs), energy and metals.

Some commodity ETFs physically hold the commodity. For example, the SPDR Gold Shares ETF buys physical gold bars and stores them in London vaults. Not all commodity ETFs, however, are structured this way. ETF managers also can replicate the commodity markets by investing in futures contracts. The ETFs United States Oil Fund (USO) and United States Natural Gas Fund (UNG) attempt to replicate the underlying commodity by buying and rolling over futures contracts.